Grandparents' 8 top college-fund plans

Parents putting together a list of potential college-funding sources for their child would typically include 529 plans, non-529 investment accounts, grants, scholarships and loans. The list might also include expected earnings from the student's part-time or summer job, along with money redirected from vacations and other discretionary expenditures.

Most likely, the list will not include grandparent gifts. Understandably, most parents don't expect that kind of help, believing that the responsibility for handling college costs rests squarely on their own and their child's shoulders.

However, studies have demonstrated a desire on the part of many grandparents to help pay college costs for their grandchildren or at the very least a willingness to chip in upon request.

Even a small amount of money can make a big difference. "Even just a few Social Security checks set aside into a college fund each year could pay for a semester or two of the grandchild's college education down the road," says Kevin McKinley, a registered investment adviser in Eau Claire, Wis., and author of "Make Your Kid a Millionaire."

Where the minds and motivations coincide, the next question is: What is the best way for grandparents to fund college? Below are some of the options along with their major advantages and disadvantages.

Pay tuition directly to the college

Advantages:

It's easy. You send the money straight to the school to pay tuition.

There is no gift tax under a special tax-code exception, regardless of how much is paid directly. (This makes it great for a grandparent looking to reduce a large estate.)

Disadvantages:

Financial aid formulas treat the direct payment by a grandparent as a dollar-for-dollar reduction in aid eligibility (the worst case) or as student income, which reduces aid by 50 percent (the best case).

Any payments for room, board or books do not qualify for the gift-tax exception.

The grandparent could pass away before the child gets to college with no assurance the money will be used for that purpose, and leaving it exposed to estate taxes.

Pay off student loans after graduation

Advantages:

The grandchild's financial aid eligibility is not affected.

The grandchild remains "invested" in his or her college education through graduation.

The grandparent can adjust the amount of help based on the grandchild's job and family situation after college.

Up to $2,500 in loan interest may be deductible by the student each year without itemizing.

Disadvantages:

Loan payments made on behalf of the grandchild are considered gifts for gift-tax purposes.

The grandparent could pass away before loan payments begin.

Make loans directly to the grandchild

Advantages:

The grandchild's financial aid eligibility is not affected.

A promise to "forgive" the loan after graduation helps to motivate the student.

A grandparent can charge a relatively low interest rate under IRS family-loan rules.

Disadvantages:

In some cases, demanding repayment can be uncomfortable, and collection can be difficult.

Interest on the loan is taxable to the grandparent but not deductible by the student.

Contribute to a 529 plan

Advantages:

Tax-free earnings offer the best opportunity to keep up with tuition increases.